Current Estimate of Economic Impact of Options Backdating

I had a discussion with Erik Lie about the experiences with Stock Options Backdating (SOBD) and the economic impact of his work. According to Erik, at least 15% of the stock options grants between 1996 to August, 2002,were backdated. Some were within 30 days of the grant date, others more egregious. The number of companies though he said that were going to come clean would be far less than 15%. Here is what we came up with.

First the assumptions:

1. # of companies that actually are investigated or asked by the SEC (currenty June 03 is 42) by June 2006 = 100

2. # of companies that will complete the 3 step process of preliminary investigation, comprehensive audit and finally restatement of results (approximately at 30-50%) = 40

3. Approximate amount of time spent performing the initial investigation = 4-6 weeks.

4. Approximate time spent doing comprehensive audit = 20-32 weeks

5. Costs in back taxes, delisting, restatement, defending lawsuits & fines = 30% of cumulative value of option grants

6. Size of company assumed on average: $500M in revenues, 2500 employees, 25+ grants under inquiry

7. Grant value net = $15M per incident

If you want to do your own analysis (how much will this cost my company), feel free to use some of these estimations.

# Expense Item Description Cost

1 Initial Investigation Typically done by Board & Audit team $1.5 M   2 Communication expenses Economic impact of communication loss to company $4M   3 Audit fees Formal investigation fees for auditors $30M   4 Restatement costs Includes delisting, cost of documentation,  $9 M   5 Taxes and fines Back taxes owed to IRS, Fines by SEC $15 M   6 Legal fees Defending lawsuits on backdating $20M  Subtotal For each company, $500M revenue $79.5M  Assuming 50 companies  Completely go over the end to end process $3.975B
Assuming remaining companies Remaining companies only go over steps 1 & 3 $1.75 B

The other part of the economic impact stems from losses in market capitalization. If you estimate currently (42 companies) lost over $63 Billion in Market capitalization (United Healthcare itself accounted for over 30% of this number) over the last 9 months. Assume that will be 50% less (since the bad news is out) for the remaining 50+ companies. The impact is another $31B. We also did a detailed analysis on this portion of the impact. Total Impact of Stock Option Backdating ~ $100 Billion.

For each company approximately = $50 to $100 Million in expenses.

http://blog.vangal.com

gregory reyes | options backdating

The Real Big Picture Around Options Backdating

If you take some time to think about the big picture story around options backdating, here are some patterns that emerge. Each is valid, and has some merit, but it gives you some reason why the general public is still not interested in the story and outraged by it, but the media and some institutional investors are.

1. CEO and Executive pay: Realistically speaking this is a weak argument at best. CEO pay has always been big and its getting bigger because lot of these executives have big risk jobs and are responsible for millions or billions of $ and thousands of employees. Add to this the legal ramifications of doing a bad job, their job is not easy. Fortune's Rick Kirkland wrote a piece on CEO pay and its an interesting read, but still does not offer any solutions.

2. Full Disclosure of pay for executives: SEC chairman Christopher Cox has stated full disclosure guidelines will be issued soon, and the "perks" that executives get do add up, but still this argument is also not very strong. There will always be the CEO parachute deals, and tax perks etc. Again we fail to see this being the big change force.

3. Better internal controls: Most companies before SOX did not have the best internal checks and balances processes for ensuring these "issues" were tracked, reported and managed. Accounting, Finance and Legal were mostly "side roles" to Sales, Marketing, Manufacturing and Engineering. Lack of internal controls is an issue for most companies that they need to fix. Its in our opinon this is a good but not the big "a-ha" compelling argument.

4. Poorly stated guidelines around gray areas: That's why they are called gray areas in the first place. Most auditors and legal firms use "judgement" around these areas such as grant and enforcement dates for options. The SEC's has stated they will have better guidelines around summer '06. This is also not a compelling argument for backdating not getting a bigger attention and outrage from the public.

5. World cup Soccer: (grin) - We made this up. Newsweek had a piece about why this time the world cup soccer has more attention of Americans. This is by far the most compelling argument why the general public does not care much about the options backdating story.

http://blog.vangal.com

Mukund Mohan is the CEO of Vangal a consulting company focused on helping companies with the stock option backdating issue.

backdating options | greg reyes

Ramifications of the Options Backdating Scandal for 2007; Some Questions

What are the top 3 ramifications of the options backdating scandal?

If you remove the usual tax consequences, shareholder lawsuits, restatement, etc. What things do we see coming down in terms of legislation/new rules and regulations and where are the opportunities?

1. Revisiting Executive compensation: It supposed to be aligned with shareholder, but as examples of Cyberonics points out, not exactly. We see examples of Google, Apple and Yahoo paying their Chief Executives only $1 as their pay and rest in options compensation. Will this change? Will companies completely stop paying salaries? Or will they stick to giving options to top executives alone?

2. Board of Director accountability: Boards do have a responsibility to shareholders. Would we see an increase in number of boards requesting higher coverage from D&O insurance? Are boards going to have their own "internal spies" in each company to help report on internal controls audits? Will board members request oversight and have responsibility over internal policies and procedures?

3. Fewer people use stock options: Many companies have started to reduce overall the number of stock grants and options to employees. There are many reasons, including expensing of stock options, backdating scandal, etc. What other alternative forms exist of incentive pay? Restricted stock has the same problems as options, i.e. if priced at the wrong time, they will have potential to drain stock holder value.

4. Audit responsibilities: Many clients we have currently deploy another set of auditors (besides the one they already use) to have an "independent" third party for internal investigation. Will this continue after the backdating has been squared away? Is there a need for a auditor to audit your auditor?

Interesting questions.

http://blog.vangal.com

gregory reyes | options backdating